CH 10

PRINCIPLES OF
MACROECONOMICS
TENTH EDITION
PART III The Core of Macroeconomic Theory
CASE FAIR OSTER

2012 Pearson Education, Inc. Publishing as Prentice Hall Prepared by: Fernando Quijano & Shelly
1 ofTefft
33
2012 Pearson Education, Inc. Publishing as Prentice Hall 2 of 33

The Money Supply
and the Federal
Reserve System
10
CHAPTER OUTLINE
An Overview of Money
What Is Money?
Commodity and Fiat Monies
Measuring the Supply of Money in the United States
The Private Banking System
How Banks Create Money
A Historical Perspective: Goldsmiths
The Modern Banking System
The Creation of Money
The Money Multiplier

The Federal Reserve System
Functions of the Federal Reserve
Expanded Fed Activities Beginning in 2008
The Federal Reserve Balance Sheet
How the Federal Reserve Controls the Money Supply
The Required Reserve Ratio
The Discount Rate
Open Market Operations
Excess Reserves and the Supply Curve for Money
Looking Ahead
What Is Money?
Money is a means of payment, a store of value, and a unit of account.
A Means of Payment, or Medium of Exchange
barter The direct exchange of goods and services for other

goods and services.
medium of exchange, or means of payment What sellers

generally accept and buyers generally use to pay for goods
and services.

What Is Money?
A Store of Value
store of value An asset that can be used to transport

purchasing power from one time period to another.
liquidity property of money The property of money that

makes it a good medium of exchange as well as a store of
value: It is portable and readily accepted and thus easily
exchanged for goods.
A Unit of Account
unit of account A standard unit that provides a consistent

way of quoting prices.

Commodity and Fiat Monies
commodity monies Items used as money that also have intrinsic

value in some other use.
fiat, or token, money Items designated as money that are

intrinsically worthless.
legal tender Money that a government has required to be accepted in

settlement of debts.
currency debasement The decrease in the value of money that

occurs when its supply is increased rapidly.

E C O N O M I C S I N PRACTI C E
Dolphin Teeth as Currency
In most countries commodity monies are not

used anymore, but the world is a big place
and there are exceptions.
In the Solomon Islands, dolphin teeth are
being used as a means of payment and a
store of value.
Note that even with a currency like dolphin
teeth there is a concern about counterfeit
currency, namely fruit-bat teeth, but also
tooth decay.
Shrinking Dollar Meets Its Match in Dolphin Teeth

Wall Street Journal
M1: Transactions Money
M1, or transactions money Money that can be directly

used for transactions.
M1 currency held outside banks + demand deposits +

travelers checks + other checkable deposits

M2: Broad Money
near monies Close substitutes for transactions money, such

as savings accounts and money market accounts.
M2, or broad money M1 plus savings accounts, money

market accounts, and other near monies.
M2 M1 + savings accounts + money market accounts +

other near monies

Beyond M2
There are no rules for deciding what is and is not money.
This poses problems for economists and those in charge of

economic policy.

The Private Banking System
financial intermediaries Banks and other institutions that act as a

link between those who have money to lend and those who want to
borrow money.
The main types of financial intermediaries are commercial banks,

followed by savings and loan associations, life insurance companies,
and pension funds.

A Historical Perspective: Goldsmiths
run on a bank Occurs when many of those who have claims on a

bank (deposits) present them at the same time.
Todays bankers differ from goldsmithstodays banks are subject to a

required reserve ratio.
Goldsmiths had no legal reserve requirements, although the amount

they loaned out was subject to the restriction imposed on them by their
fear of running out of gold.

A Brief Review of Accounting
Assets Liabilities Net Worth

or
Assets Liabilities + Net Worth
Federal Reserve Bank (the Fed) The central bank of the

United States.
reserves The deposits that a bank has at the Federal

Reserve bank plus its cash on hand.
required reserve ratio The percentage of its total deposits

that a bank must keep as reserves at the Federal Reserve.

A Brief Review of Accounting

FIGURE 10.1 T-Account for a Typical Bank (millions of dollars)

The balance sheet of a bank must always balance, so that the sum of assets (reserves and
loans) equals the sum of liabilities (deposits and net worth).

excess reserves The difference between a banks actual reserves

and its required reserves.
excess reserves actual reserves required reserves

FIGURE 10.2 Balance Sheets of a Bank in a Single-Bank Economy

In panel 2, there is an initial deposit of $100.
In panel 3, the bank has made loans of $400.


FIGURE 10.3 The Creation of Money When There Are Many Banks
In panel 1, there is an initial deposit of $100 in bank 1. In panel 2, bank 1 makes a loan of $80
by creating a deposit of $80. A check for $80 by the borrower is then written on bank 1 (panel 3)
and deposited in bank 2 (panel 1). The process continues with bank 2 making loans and so on.
In the end, loans of $400 have been made and the total level of deposits is $500.
The Money Multiplier
An increase in bank reserves leads to a greater than one-for-one

increase in the money supply.
Economists call the relationship between the final change in deposits

and the change in reserves that caused this change the money
multiplier.
money multiplier The multiple by which deposits can increase for

every dollar increase in reserves; equal to 1 divided by the required
reserve ratio.
1

moneymultiplier
required
reserve
ratio

FIGURE 10.4 The Structure of the Federal Reserve System

Federal Open Market Committee (FOMC) A group composed of the seven

members of the Feds Board of Governors, the president of the New York
Federal Reserve Bank, and four of the other 11 district bank presidents on a
rotating basis; it sets goals concerning the money supply and interest rates
and directs the operation of the Open Market Desk in New York.
Open Market Desk The office in the New York Federal Reserve Bank from
which government securities are bought and sold by the Fed.

Functions of the Federal Reserve
From a macroeconomic point of view, the Feds crucial role is to

control the money supply.
The Fed also performs several important functions for banks, such as
clearing interbank payments, regulating the banking system, and
assisting banks in a difficult financial position.
The Fed is also responsible for managing exchange rates and the
nations foreign exchange reserves.
It is often involved in intercountry negotiations on international

economic issues.
lender of last resort One of the functions of the Fed: It provides

funds to troubled banks that cannot find any other sources of funds.

Expanded Fed Activities Beginning in 2008
When housing prices began to fall in late 2005, the stage was set for a
worldwide financial crisis, which essentially began in 2008.
There has been much political discussion of whether the Fed should
have regulated more in 20032005 and whether it should be
intervening in the private sector as much as it has been doing.
It is certainly the case that the Fed has taken a much more active role
in financial markets since 2008.

The Federal Reserve Balance Sheet
TABLE 10.1 Assets and Liabilities of the Federal Reserve System, June 30, 2010
(Billions of Dollars)
Assets Liabilities
Gold $ 11 $ 945 Currency in circulation
U.S. Treasury securities 777 970 Reserve balances
Federal agency debt securities 165 288 U.S. Treasury deposits
Mortgage-backed securities 1,118 170 All other liabilities and net worth
All other assets 302 $2,373 Total
Total $2,373

If the Fed wants to increase the supply of money, it creates more reserves,
thereby freeing banks to create additional deposits by making more loans. If it
wants to decrease the money supply, it reduces reserves.
Three tools are available to the Fed for changing the money supply:
(1) Changing the required reserve ratio.
(2) Changing the discount rate.

(3) Engaging in open market operations.

TABLE 10.2 A Decrease in the Required Reserve Ratio from 20 Percent to 12.5 Percent
Increases the Supply of Money (All Figures in Billions of Dollars)
Panel 1: Required Reserve Ratio = 20%
Federal Reserve Commercial Banks
Assets Liabilities Assets Liabilities
Government $200 $100 Reserves Reserves $100 $500 Deposits

securities $100 Currency Loans $400
Note: Money supply (M1) = Currency + Deposits = $600.
Panel 2: Required Reserve Ratio = 12.5%

Government $200 $100 Reserves Reserves $100 $800 Deposits

securities $100 Currency Loans $700 (+ $300)
(+ $300)
Note: Money supply (M1) = currency + deposits = $900.

Decreases in the required reserve ratio allow banks to have more

deposits with the existing volume of reserves.
As banks create more deposits by making loans, the supply of money

(currency + deposits) increases.
The reverse is also true: If the Fed wants to restrict the supply of
money, it can raise the required reserve ratio, in which case banks will
find that they have insufficient reserves and must therefore reduce
their deposits by calling in some of their loans.
The result is a decrease in the money supply.

The Discount Rate
discount rate The interest rate that banks pay

to the Fed to borrow from it.
moral suasion The pressure that in the past the

Fed exerted on member banks to discourage
them from borrowing heavily from the Fed.

The Discount Rate
TABLE 10.3 The Effect on the Money Supply of Commercial Bank Borrowing from the Fed (All
Figures in Billions of Dollars)
Panel 1: No Commercial Bank Borrowing from the Fed
Securities $160 $80 Reserves Reserves $80 $400 Deposits

$80 Currency Loans $320

Panel 2: Commercial Bank Borrowing $20 from the Fed

Securities $160 $100 Reserves Reserves $100 $500 Deposits

(+ $20) (+ $20) (+ $300)
Loans $20 $80 Currency Loans $420 $20 Amount owed to
(+ $100) Fed (+ $20)

open market operations The purchase and sale by

the Fed of government securities in the open market;
a tool used to expand or contract the amount of
reserves in the system and thus the money supply.
Two Branches of Government Deal in Government Securities
The Treasury Department is responsible for collecting taxes

and paying the federal governments bills.
The Fed is not the Treasury. It is a quasi-independent agency

authorized by Congress to buy and sell outstanding
(preexisting) U.S. government securities on the open market.

The Mechanics of Open Market Operations
TABLE 10.4 Open Market Operations (The Numbers in Parentheses in Panels 2 and 3 Show the
Differences between Those Panels and Panel 1. All Figures in Billions of Dollars)
Panel 1
Federal Reserve Commercial Banks Jane Q. Public
Assets Liabilities Assets Liabilities Assets Liabilities
Securities $100 $20 Reserves Reserves $20 $100 Deposits Deposits $5 $0 Debts
$80 Currency Loans $80 $5 Net Worth
Panel 2

( $5) ( $5) ( $5) ( $5) ($5)
$80 Currency Loans $80 Securities $5 $5 Net Worth
(+ $5)
Panel 3
( $5) ( $5) ( $5) ( $25) ( $5)
$80 Currency Loans $60 Securities $5 $5 Net Worth
( $20) (+ $5)

The Mechanics of Open Market Operations
We can sum up the effect of these open market operations

this way:
An open market purchase of securities by the Fed

results in an increase in reserves and an increase
in the supply of money by an amount equal to the
money multiplier times the change in reserves.
An open market sale of securities by the Fed

results in a decrease in reserves and a decrease
in the supply of money by an amount equal to the
money multiplier times the change in reserves.

Excess Reserves and the Supply Curve for Money

FIGURE 10.5 The Supply of Money

If the Feds money supply behavior is not influenced by the interest rate, the money supply curve
is a vertical line.
Through its three tools, the Fed is assumed to have the money supply be whatever value it
wants.
Looking Ahead
This chapter has discussed only the supply side of the money market.
In the next chapter, we turn to the demand side of the money market.
We will examine the demand for money and see how the supply of and demand
for money determine the equilibrium interest rate.

REVIEW TERMS AND CONCEPTS
barter moral suasion
commodity monies near monies
currency debasement Open Market Desk
discount rate open market operations
excess reserves required reserve ratio
Federal Open Market Committee (FOMC) reserves
Federal Reserve Bank (the Fed) run on a bank
fiat, or token, money store of value
financial intermediaries unit of account
legal tender 1. M1 currency held outside banks +
demand deposits + travelers checks +

lender of last resort
other checkable deposits
liquidity property of money
2. M2 M1 + savings accounts + money
M1, or transactions money market accounts + other near monies
M2, or broad money 3. Assets Liabilities + Net Worth
medium of exchange, or means of payment 4. Excess reserves actual reserves
required reserves
money multiplier 1
5. Money multiplier required
reserve
ratio

CH 10

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CH 10

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PRINCIPLES OF

CASE FAIR OSTER

2012 Pearson Education, Inc. Publishing as Prentice Hall 2 of 33

The Money Multiplier

Money is a means of payment, a store of value, and a unit of account.

A Means of Payment, or Medium of Exchange

barter The direct exchange of goods and services for other

medium of exchange, or means of payment What sellers

2012 Pearson Education, Inc. Publishing as Prentice Hall 4 of 33

store of value An asset that can be used to transport

liquidity property of money The property of money that

unit of account A standard unit that provides a consistent

2012 Pearson Education, Inc. Publishing as Prentice Hall 5 of 33

Commodity and Fiat Monies

commodity monies Items used as money that also have intrinsic

fiat, or token, money Items designated as money that are

legal tender Money that a government has required to be accepted in

currency debasement The decrease in the value of money that

2012 Pearson Education, Inc. Publishing as Prentice Hall 6 of 33

Dolphin Teeth as Currency

In most countries commodity monies are not

Shrinking Dollar Meets Its Match in Dolphin Teeth

Measuring the Supply of Money in the United States

M1: Transactions Money

M1, or transactions money Money that can be directly

M1 currency held outside banks + demand deposits +

2012 Pearson Education, Inc. Publishing as Prentice Hall 8 of 33

Measuring the Supply of Money in the United States

M2: Broad Money

near monies Close substitutes for transactions money, such

M2, or broad money M1 plus savings accounts, money

M2 M1 + savings accounts + money market accounts +

2012 Pearson Education, Inc. Publishing as Prentice Hall 9 of 33

Measuring the Supply of Money in the United States

There are no rules for deciding what is and is not money.

This poses problems for economists and those in charge of

2012 Pearson Education, Inc. Publishing as Prentice Hall 10 of 33

The Private Banking System

financial intermediaries Banks and other institutions that act as a

The main types of financial intermediaries are commercial banks,

2012 Pearson Education, Inc. Publishing as Prentice Hall 11 of 33

A Historical Perspective: Goldsmiths

run on a bank Occurs when many of those who have claims on a

Todays bankers differ from goldsmithstodays banks are subject to a

Goldsmiths had no legal reserve requirements, although the amount

fear of running out of gold.

2012 Pearson Education, Inc. Publishing as Prentice Hall 12 of 33

The Modern Banking System

A Brief Review of Accounting

Assets Liabilities Net Worth

Federal Reserve Bank (the Fed) The central bank of the

reserves The deposits that a bank has at the Federal

required reserve ratio The percentage of its total deposits

2012 Pearson Education, Inc. Publishing as Prentice Hall 13 of 33

The Modern Banking System

A Brief Review of Accounting

FIGURE 10.1 T-Account for a Typical Bank (millions of dollars)

2012 Pearson Education, Inc. Publishing as Prentice Hall 14 of 33

The Creation of Money

excess reserves The difference between a banks actual reserves

excess reserves actual reserves required reserves

FIGURE 10.2 Balance Sheets of a Bank in a Single-Bank Economy

2012 Pearson Education, Inc. Publishing as Prentice Hall 15 of 33